The differences between 401k and 403b plans
I field a lot of questions regarding the various rules that govern 401k and 403b plans. Not only is it a confusing topic for the average investor, but the issue has been gaining in importance recently as these plans become more popular. The reason why they have similar names which often confuse people is that both reference the section of tax code which defines how they are organized. It may be easier to refer to them as “for-profit” and “not-for-profit” plans because therein lies the primary distinction.
If you work at a for-profit corporation, you probably have a 401k plan available to you at work. If you don’t, well, that’s an issue you may wish to raise with human resources. Most financial advisors would agree that funds accumulated through company retirement plans will be essential in light of future uncertainty regarding government benefits. A 403b is only available to tax-exempt organizations, the most common of which are schools, hospitals, and religious groups. Section 501(c)(3) of the tax code goes into considerable detail about the rules regarding organizing your business as tax-exempt. As for what the benefits are to contributing to either a 401k or 403b plan, here is the short list:
• Participants set aside money on a pre-tax basis through payroll. Let me explain what that means: If $100,000 is your taxable income in 2006, and you defer $10,000 through payroll into either plan, your taxable income is now $90,000. This is the primary benefit to contributing on a “pre-tax” basis.
• The deferral amount, $10,000 in our example, is directed to the authorized vendors working with your organization. I will discuss the vendor issue in the next paragraph as there are things to know about where you are sending your money. If you get paid monthly and you have twelve pay cycles per year, $833 would be taken out of each cycle and sent to the vendor managing your plan.
• The money invested in your 401k or 403b plan grows tax-deferred until you take a distribution, presumably at retirement. It is important to note that the “retirement” age in which you can take a penalty-free distribution is 59 ½. If you take a distribution before this age, you may be subject to a 10% early withdrawal penalty. Assuming you had contributed a total of $50,000 to your plan and it grows to $100,000 through the years, you would not have to pay capital gains tax on that appreciation. Assuming this scenario, you saved money by contributing to the plan on a pre-tax basis while you were working, and your assets grew without the concern of having to pay capital gains tax on any proceeds. Now those are some nice benefits don't you think?
As I mentioned in the second bullet, the issue of which company manages your retirement plan is quite important. Both 401k and 403b plans come in a wide variety. Once an executive decides on a 401k plan which works with his/her business, the employees generally have only that plan open to them. This keeps matters simple and provides a certain level of uniformity which is important when making decisions regarding retirement plans. Also, participants in a 401k plan are often eligible for a company match from their employer. The tax code encourages employers to match employee contributions by offering a tax-incentive to those who do. Here is an example of how an employer match works: a company matches ½ of your contribution up to 3% of your salary in a given year. If you earn $100,000 and deposit $10,000 into your 401k, your employer would answer with an additional $1,500 (1/2 of $3,000). In essence, this is free money. Most financial advisors will encourage you to research the rules regarding matching contributions and make that an early priority in your retirement planning efforts.
401k plan administrators are often subject to strict legal requirements in terms of monitoring both the contribution levels and investment activity of the participants in their plans. Many of these requirements are the result of the Employee Retirement Income Securities Act (ERISA) of 1974- designed to improve disclosure and protect employee interests. In some cases, a 403b plan may sidestep ERISA requirements. An example of this would be a plan in which the salary deferrals are at the discretion of the employee as is the method in which it is invested. Assuming no matching contribution is being made, the employer has little involvement in this plan arrangement short of announcing that the plan is available. In many cases with 403b plans, multiple vendors may be available to manage the funds. While the benefits of the 403b vehicle is uniform, there may be additional benefits or drawbacks to the provider you choose to manage your plan. For example, some 403b providers offer asset allocation tools such as quarterly rebalancing. This feature requires determining an initial "asset allocation." When your portfolio fluctuates in value, it will rebalance, once per quarter, back to your original allocation percentages. So, if the stock portion outperformed the bond portion, a certain percentage of stocks would be sold off in exchange for more bonds. This feature may help smooth out the volatility associated with having too much money invested in one asset class. Further, research shows that portfolio rebalancing may improve portfolio performance over long periods of time*. The employer or organization will generally provide you with a list of their registered 403b vendors for you to choose from. In the event that you don’t like the options available to you, getting a new vendor registered to your organization may be an option as well. Contact your plan administrator for more information on how that process works.
In terms of contribution limits, the recent passage of the Pension Protection Act makes permanent the contribution limits defined in the Economic Growth and Tax Relief Reconciliation Act (EGTRRA) of 2001. These limits are $15,000 for 401k and 403b plans if you’re under 50 years old, and an additional $5,000 (up to $20,000) if you’re over 50. These limits will be indexed for inflation beginning in 2007. You gain penalty-free withdrawal access to your retirement funds when you turn age 59 1/2. Again, I don’t know why the federal government has selected this specific age as “retirement age” but this is the magic number. There are few exceptions in which you can access this money without getting penalized such as the 72(t) withdrawal**, if you become disabled, die (in this case your beneficiary will likely get your money) or have a qualified “hardship withdrawal.” The hardship withdrawals include a few scenarios such as needing it to pay for a medical emergency which you otherwise couldn’t afford. The rules are few and far between because the goal is that you let the nest egg sit. Also, some plans do have loan provisions in which you can borrow against your account, however, check with your benefits department to determine if this feature is available to you.
There are numerous web resources which are available to help you navigate retirement plans. The 401k help center is a fabulous resource for 401k plans. The site is user-friendly and doesn’t make any endorsements which could jeopardize the site’s credibility. For questions regarding 403b plans, 403bwise is the authority site. They have an excellent forum with experts who will answer your questions regarding both 403b and 457 plans. For more broad news on the retirement plan environment, including updated news on legislation and current trends, visit PlanSponsor.com. The information on this website is very comprehensive and most often geared towards financial professionals. That being said, I recommend you visit the site and evaluate its resources on your own. They also have a blogwritten by the talented Nevin Adams.
As always, feel free to contact me with your questions.
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*www.bernstein.com The Science of Psychology of Rebalancing
**Section 72(t)(2)(A)(iv) provides an exception for payments that are part of a series of substantially equal periodic payments made for the life of the account holder/s and his or her designated beneficiaries.